How risky should I be with my 401(k) investments?

I recently started my first full-time job at a company that offers a 401(k) with a match. I am a pretty savy and knowledgeable investor, however, I'm not sure how risky I should be with my investments considering it is my first and only retirement account. Do I risk losing some of my funds for higher gains, or is it not worth jeopardizing my retirement?

You don't say how old you are, but if you are starting your first full time job, I will assume you are in your early 20s. If so, put away as much as you can and invest it all in equities. Yes, they are more volatile than bonds, but that's a good thing because they also have higher long-term return. In your lifetime you will live through several bear markets; don't worry. In fact, a bear market just allows you to buy more shares with the same money. Just don't confuse paper losses with real losses. If your investments decline and you don't sell, you won't take a loss.

Keep in mind that investment risk is just as normal and natural as weather. Markets move in the short-term to the whims of supply and demand, and human emotion. But markets are made up of individual companies that produce steady revenue and earnings. Their real value tends to increase, regardless of what their market value does in the short-term. Don't be concerned about short term market risk if you are investing money you won't need for 40-plus years. Instead, invest in good quality companies and hold for the long-term.

Given you just started your first full-time job, time is on your side, so you can probably withstand significant volatility given that you are 20-30 years from retirement (and you have time to recover from potential losses before then).

With that in mind, you can probably go 80/20 or 90/10 split in equity/bond funds, with allocating both to domestic and international funds. Make sure you rebalance every 6 month to 1 year and as you get closer to your retirement age, you should shift allocation to something more conservative.

Your company plan should offer 10-12 mutual funds to choose from, or even a target fund geared toward your retirement year, which will start off more aggressive and gradually shift allocation towards holding more bond funds. Some 401(k) plans have self-directed brokerage options linked to them, so it pays to ask, as those you have access to have more options to choose from, like individual stocks, bonds, and ETFs.

The most important thing is to maximize your contributions to the plan not only to get the company match, but to get the maximum savings of $18,000/year (up to $54,000 including company match) and benefit from compounding of interest.

First, if your employer is matching your funds in the 401(k), you can afford to assume more risk. If you have 20+ years till retirement age, you can assume more risk.

I recently looked at the average annual return of the S&P 500 index for the last 30 years and it was 9.24%. For the same period, the Barclays US Aggregate Bond index was 6.66%. Assuming that these two indexes represent the stock and bond markets, you can use them for for a general rule of thumb estimate for your long-term expectations. Generally speaking, you can expect 9.24% returns for stocks and 6.66% for bonds. So, a moderately aggressive portfolio would be 75% stocks and 25% bonds, thus expecting an 8.6% return over 30 years. Moderate portfolios of 60% stocks and 40% bonds would be 8.2% and a 50/50 split would be 7.95%. The point being that over a long period of time, there is not that much difference in returns between a 50/50 and a 75/25 split. The difference is that the 50/50 split will not have as significant ups and downs as the 75/25 split.

So, if you are several years from retirement and your employer is matching, consider 75/25 or even an 80/20 split between stocks and bonds. You won't be disappointed over a long period (over 15 years). I would recommend an automatic rebalance of your investments in the plan annually.

The best thing for you to do first is understand how much time you have to invest. If you are 10 years or less away from retirement, you may want to take less risk. If you are 30 or more years from retirement, you may be able to take more risk. Understand that the money you are putting into your 401(k) is meant to be used until you retire because there are tax penalties if you take out the money prior to age 59 1/2. If you have a lot of time before you retire, general rule of thumb is selecting some index funds that will help you be diversified. The idea with the 401(k) is that if you have more time, then you can take more risk to get more reward. Do not expect or plan to use your 401(k) in case of an emergency. You should have other funds, less risky and liquid, for emergencies.

Since you are a smart investor, you know that it is important to buy low and sell high. The advantage with a 401(k) is that you do not have to necessarily guess if you are buying when the market is high or when the market is low, and you shouldn't try to time it. Here is the big advantage you have with a 401(k); you have "dollar cost averaging" built in. If you are many years away from retiring, you can utilize dollar cost averaging to your advantage. The key to dollar cost averaging is to continue to contribute to your 401(k) regardless of what the market is doing, because you will buy shares at index or markets highs and low points and it will average out over time. So, there is no need to try and time the selling high and buying low. It is also that much more important to "hang in there" when the market isn't doing as well to make sure you are buying low.

If you do not have a lot of time before you retire, then dollar cost averaging may not work to your advantage and you may want to be more prudent on your risk allocation.

One last word of advice, do not chase returns, pick some solid index funds, and passively invest if this is indeed your long-term retirement funds.

Warren Buffett says you find out who's swimming naked when the tide goes down. I'm glad you're not waiting for the market to go down to find out you're not covered the way you thought!

The answer to your questions depends on your (a) need, (b) ability and, (c) willingness to take risk. Let's go through them one by one.

Your need to take risk has to do with how much you need your investments to grow. To take an extreme example, if you plan to save 40% of your lifelong income for retirement, you don't need to take much risk. You'll accumulate what you need by saving alone rather than investment growth. If you save 15% of your lifelong income for retirement, you need that money to seriously grow.

Your ability to take risk has to do with your timeframe. If you don't need to touch your retirement savings for decades, you can ride the ups and down of the market and benefit from long-term growth. By contrast, if you need the money next year, you wouldn't likely have time to ride out a downturn.

Your willingness to take risk has to do with how stressed you get when the market goes down. Some people stay cool as cucumbers (think Buffett again). The worst thing to do is to freak out and get out of the market when it goes down. So, don't put yourself in a position where you'd be compelled to hurt yourself.

If you're young, you've got the ability to take a lot of risk. The vast majority of young investors have need to take risk (unless they are extreme savers or have very rich parents). The willingness to take risk depends on personality.

Here's a tool to asses your risk profile. There's a fee, but it's a good tool many professional advisors use with their clients.

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